I'm Managing Editor for Business News at Forbes, helping to lead our print and online coverage of everything from Detroit to Washington to Hollywood. Previously I directed online news for The New York Times, was business editor of NYTimes.com and co-founded DealBook, a popular information service for Wall Street. Follow me on Twitter: @danbigman

Facebook Ownership Structure Should Scare Investors More Than Botched IPO

For all the huffing and puffing and blown around houses associated with Facebook’s ugly IPO, there’s a looming problem associated with the company that’s getting lost. That’s a pity, because over the next few years it promises to have a more profound influence over the fortunes of Facebook investors than anything else.

I’m not talking about mobile, or advertising or regulation. I’m talking about the company’s dual-class share structure. As you likely know, founder Mark Zuckerberg set up the company so that Class-B shares (which he controls) carry ten times the voting power of the A-shares. That means he owns about 18% of the company, but controls more than 50% of the voting power.

It’s the preferred setup of SuperFounders and Family Scions from Larry Page and Sergey Brin at Google to Zuckerberg’s mentor, Don Graham at the stumbling, fumbling Washington Post Company to Silicon Valley newbies like Zynga and LinkedIn.

Thanks to this setup, what Zuckerberg says goes–right into the grave (he can name a successor to take control of the company in case of his death. See page 20/21 of the S1.) Because more than 50% of the voting power for the board of directors is held by one guy, Facebook listed itself under what’s called the “controlled company” exception to corporate governance rules for public companies. That means no independent board members, no compensation committee, and no independent nominating function.

“This concentrated control,” the company writes with delightful bluntness in the S1, “will limit your ability to influence corporate matters for the foreseeable future.”

There’s little evidence (at least that I can find) that these kind of companies underperform peers in the market, or even trade at a discount to single-share peers. But a study by Paul Gompers, Joy Ishii and Andrew Metrick found that while large ownership stakes in insiders’ hands tend to improve corporate performance, heavy control by insiders weakens it. They tend to take on more debt, rather than dilute control through share offerings than single-share companies. Other studies found CEOs enjoy higher levels of compensation and shareholders enjoy less return on capital investments, while wasting cash and chasing goals that are personally important to those in control–not shareholders.

Overall, about 6% of US companies have this kind of structure, representing about 8% of the market’s overall capitalization. Defenders say that it insulates those in control from having to react to short-term swings in the market so they can focus on the long-term. On occasion that works (Comcast), but often it doesn’t (Washington Post, The New York Times).

In the case of Google, it allows founders Brin and Page to hold only 21.5% (as of last summer) of the economic share of the company but exercise 73% of the voting power. When they decided to shakeup their leadership team and put Page in charge, it was their decision in the end, no one else’s. The jury is out on whether it is working, with shares off 6% so far this year.

At Viacom, according to research by investment bank Houlihan Lokey, 88-year-old Sumner Redstone controlled just 10% of the economic share of the company, but 79% of voting power. VIA.B shares are up 8.7% since 2007, just behind the overall Nasdaq’s 9.9%. Shareholders in The New York Times company wish they were that lucky, down more than 75% since 2007. Yes, it’s been a terrible time for media, but The Sulzberger Trust–which controls just 0.6% of the economic share of company–controls 90.1% of the voting and seem utterly unwilling to let anyone else take a turn at the tiller.

They’re hardly alone. Owners with this kind of control are basically bulletproof. You can never get rid of them, no matter how they perform. They aren’t subject to hostile takeovers, and almost never change the structure once they put in place (among all US public companies it happened only 159 times between 1995 and 2002 according to one study.) Why do investors put up with it? “The simple answer is that they don’t have much choice,” posits The New Yorker’s James Surowiecki. “Investors these days are hungry for any kind of return…This makes investors willing to accept terms that they would once have found intolerable.”

True enough, but Institutional Shareholder Services got it right back in February when they called the arrangement at Facebook “a governance profile with a defense against everything against hubris.” ISS got it wrong when they said the Facebook IPO presented “a Hobson’s choice: accept governance structures which diminish shareholder rights and board accountability, or miss out on what appears to be one of the hottest business models of the internet age.”

Why’s that wrong? Because of the way Zuckerberg has built his company, you aren’t betting on his business when you buy FB. You’re really just betting on him.

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Google wouldn’t be the company it is today if it was swayed by shareholders. Do you really think shareholders would put up with Google giving its mobile operating system away for free, with no immediate return on investment? Hell no, but their leadership thinks long term, and i think they will be around a whole lot longer and be a lot more influential for that reason.

Can’t say for sure if being swayed by shareholders would have been bad or good for Goog, tho I’d bet a little sway would have helped keep them on course and out of the weeds on some of their stranger and more distracting initiatives. As for the giving away operating system, yeah, that was bold. But then they turned around a year later and bought Motorola anyway. Bit confusing, at least to me. I will agree with you 100% when you say that they’ll be around a whole lot longer and be a lot more influential then if board members had an actual say.

the strange and distracting initiatives are what keep the company well rounded. you never know when two very different fields/projects can come together and form something amazing. this is the whole point of the google labs, to try things no one has thought of before

It’s simple. Now that stocks are somewhat down, you can find 1 million reasons for it. Tomorrow you’d say that investors are concerned about Facebook’s Blue color, or Menlo Park or Dublin offices or something else.

When stocks go up, you’ll be the same person talking about how great FB is.

The simple fact is, there are so many things going against FB at this moment, from arm chair analysts leveraging this opportunity to Media trying to cash in on FB’s popularity with negative articles. Yet, Facebook is still worth over 90 Billion dollars (still huge).

This just shows how solid the stock is and how strong the company is. Let the dust settle and FB get into the act, we’ll see the same people finding reasons for why FB is the greatest thing to have ever happened to the mankind :P

I say if you don’t like the structure. Don’t invest! Problem solved. If you’re investing in Facebook you’re investing in Mark Zuckerberg and his team and you shouldn’t want to interfere or inject your two sense into how he manage the business (or how he dresses) no matter how much stock you own!

These media companies are failing because they rely on ad revenue dictated by web-traffic volume. But the central location to share such media is through social networking sites like Facebook and Twitter. Therefore, the traffic does not stay on the initial media source’s website very long. People read the article, then they “share” in on Facebook or Twitter, and then the article gets the most attention and is actually discussed between thousands. The initial source of the media gets overlooked and takes the role of “temporary contributor” because of this.

In order to fix the problem, I think that media websites that you mentioned such as New York Times and Washington Post should focus on the “Adicle Concept.” It’s where the article IS the ad. Rather than being a nuisance readers by having ad banners take-up web-space and (virtually get ignored)by the traffic, media companies can publish articles to the web that advertise for companies so that the ads are being utilized most efficiently by drawing a genuine interest from the readers.

Plus, the readers will feel more close and personal to the website as they are not bombarded with ads. It makes them feel like they are a part of the website and not a part of a business revenue strategy. This would also help media websites not be cheated out of their contributions to the public as the “Adicles” are paid for by the companies that they are advertising. Furthermore, it helps all businesses involved have a chance to connect with the public by recognizing their “social responsibilities” and effects on society overall.

Wow! Seems like Forbes is already on board with this concept! Kudos to you guys at Forbes, because that is the future of the media market if it desires to stay competitive with social media controllers such as Facebook and Twitter.

I predict that one day there will be no more ad-banners, instead readers will enjoy user-based content “endorsed” by companies in order to create more realistic and personal advertising. I believe this, because I am a reader myself, and I would become genuinely interested in content that relates to the business in a non-traditional advertising form. As I said before, ads are a nuisance while browsing.

It seems that “Advoice” is an upcoming platform at Forbes, so I look forward to participating when it is released.

However, just to clarify, I’d like to cite an example to see if my “Adicles” concept matches the “Advoice” concept. For instance, right now there is a Microsoft ad for WindowsAzure on the right side of the page. Instead of seeing this banner as a nuisance, there would be a headline displayed in the same place that the ad would normally be located, and the headline would link to the article that indirectly advertises the WindowsAzure platform.

The headline might say, “How this start-up company revolutionized its app-hosting process with Microsoft’s new platform”

Then the article may go on to tell about how the quality assurance complications between the startup and its outsourced developers located in India reduced due to the “cloud platform” offered by WindowsAzure. “This platform helped Company X bring their app products to the market in 50% of the time, allowing them to surpass their competition. Yada yada yada yada…”

Microsoft would simply endorse the article and use it as a form of advertisement. No one can argue that word-of-mouth is the most effective advertising. If other app developers saw that the threads below such an article included “review-like” comments from companies that have struggled with the same problem and/or switched to WindowsAzure, then the entire “Ad” or “Article” (hence the name “Adicle”) would become a genuine interest for readers rather than a nuisance. Yet, Microsoft would be simultaneously advertising their new product while avoiding their formal “nuisance approach” in the form of a banner.

Is this the same type of concept that Advoice will use? Or am I slightly off-course concerning the intentions of the new Forbes platform, “Advoice?”

I seem to remember reading this IPO was because of regulations not because FB wanted to go public. If it was upto the investors and banks, they would dismember the company if that’s what was required for short term profit. They have no long term vision and should have very little say in the future direction of the company and its offerings.